Foud Twal, the most senior Catholic figure in the Holy Land, at Midnight Mass in St Catherine's church in Bethlehem. Photograph: Abed Al-Hashlamoun/AFP/Getty Images

Deep in the Grotto of the Nativity, where a 14-point silver star set into a marble slab marks the spot where Jesus is believed to have been born, the atmosphere of spiritual serenity seemed a world away from the swirling, and occasionally fractious, Christmas Eve crowds above.

Midnight mass at St Catherine's was the finale to a day of celebration and ceremony in Bethlehem, boosted this year by being the first Christmas since the United Nations recognised the state of Palestine last month and the Nativity church was named a world heritage site by the UN's cultural arm, Unesco, in June.

Sweet piercing singing echoed around the grotto, beneath the 4th-century Church of the Nativity's cavernous nave, as midnight approached. Nuns and pilgrims perched on steep stone steps leading to the small chapel, most apparently locked in silent prayer. Many knelt to kiss the site where the newborn Jesus had lain in his crib.

Outside the church, thousands of people packed Bethlehem's Manger Square, flanked by the Church of the Nativity at one end and St Omar's mosque at the other. Despite the Palestinian Authority's financial crisis, no expense had been spared on festive lighting throughout the city, culminating in a 15-metre (50ft) Christmas tree, lit by thousands of green and gold lights.

Hawkers of sweet tea, thick Arabic coffee and lurid pink candy floss were doing good business, along with falafel and shawarma stands on the edge of the square. Close to the church, armed police set up crash barriers to hold back the crowds and channel those in possession of precious crested tickets through to midnight mass. Occasional mild altercations broke out as police blocked entry to the ticketless, or delayed passage into the church to allow for the arrival of dignitaries, including the Palestinian president, Mahmoud Abbas.

Inside St Catherine's, the Franciscan church within the Nativity complex, worshipers who had failed to secure a place on the wooden pews beneath the soaring arches sat on the floor, leaned against pillars and crowded into aisles. As the service was conducted in at least four languages, mobile phones were raised above the heads of those without a view to record the service in the hope of reliving it later. A baby in a miniature Santa outfit slept throughout on a pew, his arms flung above his head.

The Latin Patriarch, the most senior Catholic figure in the Holy Land, led a procession from Jerusalem's Old City to Bethlehem's Manger Square, stopping at the Mar Elias monastery between the two cities, close to where Israel's first new settlement since 1997 is to be built following official authorisation last week. The procession entered Bethlehem through a massive metal gate in the imposing concrete wall separating the city from Jerusalem, opened specially for the occasion by the Israeli military, which controls exit and entry.

In his address, the patriarch, Fouad Twal, said this year's festivities celebrated both "the birth of Christ our Lord and the birth of the state of Palestine". But, he added, "the path [to statehood] remains long, and will require a united effort".

He appealed to "politicians and men of good will to work with determination for peace and reconciliation that encompasses Palestine and Israel in the midst of all the suffering in the Middle East. Please continue to fight for a just cause to achieve peace and security for the people of the Holy Land."

Around Manger Square, traffic congestion threatened outbreaks of Christmas road rage. In the plaza, the drums and bagpipes of at least two dozen Palestinian scout groups competed with pilgrim choirs and the Muslim call to prayer, emanating from St Omar's mosque.

A group of young women in traditional Palestinian dress greeted the patriarch. "I am wearing this to show that our history and our culture is not dead, that there is a connection from the past to the future," said Selina Mukarker, 16, clad in a robe which she said was 120 years old. She described her Bethlehem childhood as "living in a big cage".

The crowd was overwhelmingly Palestinian. The number of foreign tourists visiting Bethlehem over Christmas was thought to be down from last year, after cancellations following the eight-day conflict between Israel and Gaza last month. However, Palestinian tourism officials were encouraged by increasing numbers opting to stay overnight in the biblical city instead of being bussed in and out by Israeli tour operators.

Christoph Fuchs, 22, a student from Munich, said he was not surprised by the presence of the wall and Israeli settlements around Bethlehem as he had previously visited the city four years ago. "But it's still depressing. Everything seems just as bad," he said.

Meanwhile, Jerusalem planning officials approved on Christmas Eve the construction of more than 1,200 new homes in the settlement of Gilo, which overlooks Bethlehem.

Amid the Manger Square crowd, Nour Odeh, spokeswoman for the Palestinian Authority, said the UN vote "has made us feel we are not alone any more". Christmas was "a time to set aside the difficulties of being Palestinian. It is a time for hope."